The Strait Story on Oil Prices

It’ll be a hair-raising year for black gold as it is, but something could happen over the next several months that would absolutely destroy the market as we know it, writes MoneyShow editor-at-large Howard R. Gold, who also writes for The Independent Agenda.

The Dow Jones Industrial Average is around 13,000, the S&P 500 has topped last spring’s highs, and people are feeling better about the US economy.

But just when you thought it was safe to go back in the water, gasoline prices have surged amid fears of a new Persian Gulf conflict. The price of oil accounts for two-thirds of gasoline prices, and Brent crude has been rising sharply since last fall, to around $120 a barrel now.

Regular unleaded gasoline sold for $3.72 a gallon nationwide as of February 27, according to the US Energy Information Administration. That’s a 20-cent-a-gallon jump over the past two weeks, and 24 cents below its peak last year. Gasoline also crossed the ominous $4 threshold on the West Coast, where it averaged $4.12 a gallon.

Continued high gasoline prices could put the kibosh on the economic recovery, which has been picking up steam in recent months.

Although the US economy is far less dependent on energy than in years past, “the price of oil was a contributing factor in at least some of the recessions we’ve seen in the US since World War II, “ said economist James Hamilton of the University of California, San Diego, who writes the popular Econbrowser blog.

Prof. Hamilton points out that “it takes more than one thing” to cause a recession, even those that followed the Arab oil embargo of 1973 and the Iranian revolution of 1979.

But higher gasoline prices get people to cut back on driving and stop spending money on other things. High energy costs also squeeze profit margins of companies, like truckers and airlines, whose businesses are tied to fuel prices.

So, although I’m not predicting high gas prices will cause a recession, they could be a dark cloud over the economy in the months ahead.

This year’s spike in gas prices is happening much earlier than last year’s, when unleaded averaged $3.97 in early May, just ahead of summer driving season.

Last year, the Libyan civil war took down that country’s 1.5-million-barrel-a-day export production. Also, the Federal Reserve’s “quantitative easing” (QE2) policy prompted a boomlet in risky assets and frenzied speculation among oil traders, as I wrote here last year.

We’re seeing signs of that this year, too, but unlike 2011, supply isn’t a problem in much of the US. The main driver now is fear of an oil embargo against Iran, and especially of a military conflict over the Islamic Republic’s nuclear facilities.

The US and the European Union are pushing to get Iran to stop its nuclear program, which Tehran repeatedly claims is for peaceful purposes. Nobody believes them, of course, and the International Atomic Energy Agency’s inspectors report Iran’s capacity to enrich uranium is growing steadily.

Sanctions are tightening, too. The European Union has agreed to wind down purchases of Iranian oil by July 1. Japan is also phasing out its purchases of Iranian oil, but China and India are not expected to participate in an embargo.

That could reduce Iran’s oil exports by 40%, or one million out of its 2.5 million barrels exported a day. (Saudi Arabia has pledged to cover any shortfalls.) But experts don’t think Iran can economically sustain that big a drop in its exports, and government officials have threatened military action in case of embargo.

Stephen Schork, editor of The Schork Report, an energy letter based in Villanova, Pa., says Iran may get around an embargo. And he thinks the world is better positioned to weather this crisis than it was last year, when “Libyan production virtually went down to nil because everything was shut down.”

“With Iran, you’re not going to lose all the oil," he said.

He told me Saudi Arabia is hiking prices in Europe—which doesn’t have an alternative source to Iran—while slashing them in Asia. Iran has responded by cutting prices there, too.

Meanwhile, “there’s a ton of oil in the US sitting in the mid-continent” that will be ready to ship to Gulf Coast refineries by June 1, he told me, although there are some refinery bottlenecks on the East Coast.

And of course, President Obama may tap into the Strategic Petroleum Reserve, as he did last year, when the US and the International Energy Agency released 60 million barrels from strategic reserves.

But Israel is the wild card. Its government has warned repeatedly that it is prepared to take military action to prevent Iran from getting nuclear weapons, which it considers an “existential threat.” Defense Minister Ehud Barak warned recently that Iran’s nuclear program was approaching a “zone of immunity” where any attack would be ineffective, and that sanctions must be tightened “as soon as possible.”

Barak is in Washington for talks with top US officials ahead of a meeting between Israeli Prime Minister Benjamin Netanyahu and President Obama next week. I have a feeling Iran will be on the agenda.

Schork said fear of an attack and its aftermath have shaken oil markets. “This is something that’s been in the market. Now it’s being pushed to a head, with the IAEA and Europe taking the leadership. People are sitting up and taking notice,” he said.

The big fear is that Israel will attack Iranian nuclear facilities, and Iran would respond with rocket attacks on Israel from Iran itself and from its Hezbollah allies across the Israeli border in Lebanon. With all the turmoil in Syria, which Russia and Iran support, there’s even potential for a larger Mideast war as in 1973.

But the nightmare scenario is that Iran attempts to close the Strait of Hormuz, the narrow waterway through with 20% of the world’s oil flows. According to Prof. Hamilton, the damage would be incalculable.

“If we look at the Strait of Hormuz [closing], that would be a bigger shock than anything we’ve seen historically,” he told me. “We’ve had maybe a half-dozen episodes where there’s some major disruption…Hormuz would be twice as bad as any of those.”

He’s not as worried about even an effective embargo. “I think if we just [take out] Iranian production, that would still be a 50% increase in price,” he said. “If you take out the Strait, nobody can get oil at any price.”

If you do the math, we could be looking at oil in the high-$100 range, which easily would translate into $5-a-gallon gas prices. The last time they were above $4 a gallon nationwide was in June and July 2008.

Both Schork and Hamilton think some diplomatic resolution is possible, but Schork expects prices to stay high for some time unless there’s a major breakthrough with Iran, which he sees as unlikely.

“$5 at this point is the probability,” he said. “It certainly will go on for the summer.”

Summer? It’s just the beginning of March. That wouldn’t be good news for the economy or the stock market, where the bulls seem to have blithely ignored the gathering storm.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and catch his coverage of world events and the 2012 elections at his political blog, www.independentagenda.com.